Unfortunately market monetarism is still a fringe movement, even less popular than other heterodox theories like ABCT. So I have to constantly act like that nerdy guy who barges into a party he wasn’t invited to. Noah Smith recently quoted John Cochrane on the problems with traditional Keynesianism and traditional monetarism:
The conventional way of reading this graph is that inflation is unstable, and so needs the Fed to actively adjust rates…When inflation declines a bit, the Fed drives the funds rate down to push inflation back up…When inflation rises a bit, the Fed similarly quickly raises the funds rate.
That view represents the conventional doctrine, that an interest rate peg is unstable, and will lead quickly to either hyperinflation (Milton Friedman’s famous 1968 analysis) or to a deflationary “spiral” or “vortex.”…
But in 2008, interest rates hit zero…The conventional view predicted that the broom will topple. Traditional Keynesians warned that a deflationary “spiral” or “vortex” would break out. Traditional monetarists looked at QE, and warned hyperinflation would break out…
The amazing thing about the last 7 years in the US and Europe — and 20 in Japan — is that nothing happened! After the recession ended, inflation continued its gently downward trend.
This is monetary economics Michelson–Morley moment. We set off what were supposed to be atomic bombs — reserves rose from $50 billion to $3,000 billion, the crucial stabilizer of interest rate movements was stuck, and nothing happened.
Then Noah Smith adds the following comment:
This is a powerful argument, and I think that those who sneer at Neo-Fisherism don’t take it seriously enough.
That said, there are some serious caveats.
And before Noah explains his views, this is where I barge in, like a student eagerly waving his hand up to be called on.
Let’s slow down and figure out what John Cochrane is glossing over. He was right that an interest rate peg was supposed to lead to hyperinflation or a deflationary vortex. But Friedman did not believe that this applied at the zero bound. Rather he thought that when nominal rates were positive an interest rate peg makes the quantity of money endogenous, and that’s where the problems come in. (Indeed Friedman once argued for zero nominal interest rates on “optimal quantity of money” grounds.) Now in fairness to John, he’s right that traditional monetarists overestimated the impact of base increases at the zero bound, or more precisely didn’t adequately account for the distinction between temporary and permanent injections (which Krugman modeled in the now-famous 1998 paper.) So it’s fair to criticize the traditional monetarists, even if they didn’t expect price level indeterminacy at the zero bound.
And it’s also fair to criticize the Keynesians for their flawed Phillips Curve approach, which predicted more deflation than we actually got (even more so in countries like Britain.)
But unless I’m mistaken the market monetarists got this exactly right. Let’s take it in steps:
1. We accept the distinction between temporary and permanent currency injections. So like Krugman we said there’d be no high inflation. He relied more on Phillips Curve thinking and IS-LM, we relied more on TIPS spreads (the market part of market monetarism.)
2. But unlike many Keynesians, we thought QE could be effective at the zero bound. This would also prevent deflation from occurring. Which it did. Further support for the model occurred after the BOJ adopted a more expansionary policy, and deflation ended. And of course markets (stock and forex) in the US, Europe and Japan clearly believe monetary policy matters at the zero bound. In my view that means a University of Chicago guy like John Cochrane should be required by law to believe the same thing.
Noah Smith then criticizes the neo-Fisherites:
Our basic supply-and-demand intuition says that demand curves slope down and supply curves slope up. Dump a lot of a commodity on the market, and its price will fall. Start buying up a commodity, and its price will rise.
Neo-Fisherianism goes against this intuition. Suppose the Fed lowers interest rates. Abstracting from banks, reserves, etc., it does this by printing money and using that money to buy bonds from people in the private sector. That increase in demand for bonds makes the price of bonds go up, and since interest rates are inversely related to bond prices, it makes interest rates go down.
Now, you can write down a model in which this doesn’t happen – for example, a model in which Fed money-printing-and-bond-buying stimulates the economy so much that interest rates end up rising instead of falling. But in practice, it looks like the Fed has total control over interest rates (at least, the Federal Funds Rate; let’s put aside the question of heterogeneous interest rates).
So when the Fed lowers interest rates, it prints money in order to do so. But in a Neo-Fisherian world, that makes inflation fall – in other words, it makes money more valuable. That’s worth repeating: In a Neo-Fisherian world, dumping a ton of new money on the market makes money a more valuable commodity.
That is weird! That totally goes against our Econ 101 intuition! How does dumping money on the market make money more valuable??
I think this is exactly backwards, but nonetheless Noah ends up in the right place. How he ends up being correct despite flawed reasoning is an exercise worth spending some time on.
Let’s start with the supply and demand model, which Noah cites in support of his advocacy of what’s usually called the “liquidity effect.” The supply and demand model assumes perfect competition and price flexibility. But in that sort of world money is superneutral, even in the short run. Do you see the problem? Neo-Fisherism is basically a model that claims money is superneutral, even in the short run. In this model a lower rate on money growth immediately causes lower inflation. And since prices are flexible in a S&D model there is no liquidity effect. Thus monetary policy doesn’t impact real rates, and hence slower money growth leads to both lower inflation and lower nominal interest rates.
In contrast, Noah assumes the lower interest rates are caused by “printing money.” But what makes him think that? Because it’s true? OK, it probably is true in some cases, but it’s not true if NeoFisherism is true. So it’s a weird assumption to use when criticizing NeoFisherism.
There are all sorts of problems with trying to apply S&D in the way that Smith tries to. If you want to apply the S&D model to bonds, you need to account for the fact that money is itself the medium of account. So changes in the supply of money change its value, and hence change the supply and demand for bonds. That’s the story of the 1960s and 1970s. Printing lots of money made bond yields rise. (It’s also the problem with “Cantillon effect” claims that the Fed buying bonds helps bondholders.) Long-term T-bond holders were devastated by the Great Inflation. So no, there is no S&D presumption that more money should lead to lower nominal interest rates, even if the new money is used to buy bonds (as it was in the 1960s and 1970s).
Take a look at money growth (the base) and short-term nominal interest rates from 1948 to 1982.
Unfortunately it’s a big mess, because monetary policy is partly endogenous. But if you look closely you can see some support for Neo-Fisherism, but also why people like Noah and I are a bit skeptical.
The long run trend looks Neo-Fisherian. But it was a struggle to even find that much correlation. Other periods of American history are far messier. For instance, there was virtually no expected inflation under the gold standard. And recently base growth has soared at the zero bound. So the Great Inflation is the period where it seems to work best. The Fed gradually printed money at a faster and faster rate. Inflation rose higher and higher, and so did nominal interest rates.
But if you look closely you’ll also see the opposite. Right before the 1960, 1970, 1980 and 1982 recessions, nominal rates spiked upwards and yet money growth seemed to slow. In those cases a tight money policy raised nominal rates, and this lowered inflation, perhaps with a slight lag due to sticky prices.
In fairness to the Neo-Fisherites, if I’d shown you the correlation between inflation and nominal rates it would have been even stronger. For instance, higher inflation leads to higher velocity. So when money growth rose during the Great Inflation, so did velocity. This meant that inflation rose by even more than money growth, and the high inflation helps explain why nominal interest rates were so much higher than money growth during 1979-81—velocity was rising as there was a flight from the dollar.
Lower interest rates won’t cause low inflation, but a tight money policy that leads to low inflation will also lead to low nominal interest rates much more quickly than most Keynesians assume. In other words the income and Fisher effects begin to dominate the liquidity effect more quickly than you might assume, and one can construct plausible thought experiments where Neo-Fisherism is even true in the short run. But in the world we currently live in, a September rate increase by the Fed will lead to lower inflation than not raising rates in September.
Cochrane and Williamson don’t have to convince me, they have to convince Wall Street. One nanosecond after Wall Street is convinced, I’m on board.
I also have recent posts on the interest sensitivity of the economy, and rational expectations, over at Econlog.